ZWC Insight|Patrick Cheung, managing partner of ZWC Partners: Only companies with moats can deliver high growth
May 19, 2020

Xiaolin Yin CEIBS Business Review

A believer of growth and value investment, Patrick Cheung, managing partner of ZWC Partners, holds a core principle when judging an investment decision: whether a company can benefit users and society by improving industry efficiency via technology innovation or revolutionary business model. In essence, such “altruism spirit” is an arbitrage investment philosophy built on quality companies.

Is it the worst of times? Venture capitalists do not think so.

In April, intelligent logistics platform Kuaitu Logistics (KTU56.COM) completed approximately RMB 200 million in series B financing led by ZWC Partners together with Country Garden VC Fund. Existing investors Aotuo Investment and Sinovation Ventures made follow-on investments.

In the meantime, the AI and technology service provider 4Paradigm also completed US$230 million series C+ financing, valuing the company at around US$2 billion. A- list new strategic investors include Cisco, Citic Bank and Lenovo. Green Pine Capital and Co-Stone Capital joined as finance investors. ZWC was the co-investor in series B financing.

Besides that, Patrick has recently closed other follow-on investments, such as Boss Zhipin, Xiaodian, Leyan Tech, a developer of intelligent customer service robot and Wiz.AI, a Singapore AI company.

As a matter of fact, Patrick is hardly a contrarian trader. Due to his strict requirement on timing and valuation, Patrick has been waiting for the right moment most of the times. The COVID-19 pandemic did not stop him making investment when the right moment appears.

01
Benchmark: “Altruism spirit” being the trump card of value investment

The question of how macro economy shapes investment behavior captivates Patrick while he is reading The Holy Grail of Macroeconomics: Lessons from Japans Great Recession by Richard C. Koo recently.
The world has been in low interest rate environment from 2009 to 2017 and the pandemic is likely to extend the low interest environment for a prolonged period. Asset’s intrinsic value will increase as the discount rate decreases, thereby pushing up asset prices. Investors will tend to reduce cash or cash equivalents in their asset allocation and try to obtain higher returns by increasing risk appetite. Patrick believes that equity asset will be one of the most attractive investments in the next five years.

“The biggest winners will be the innovative companies that can build moat in the long run,” said Patrick, “We are not a fund that buy into hype. Our investment pace will not be subject to how good or bad the market is. Following our investment thesis and methodology, we favor industries and companies with long-term values.”

A believer of growth and value investment, Patrick holds a core principle when judging an investment decision: whether a company can benefit users and society by improving industry efficiency via technology innovation or revolutionary business model. In essence, “altruism spirit” is an arbitrage investment philosophy built on quality companies.

Patrick particularly likes a company called Yunhu Technology, which specializes in providing SaaS and cloud services to clinics in tier 3-5 cities, offering lab testing and logistics services. The company helps small clinics deliver lab testing services, not only improve clinic revenue but bring convenience to local patients. With an extendable business model, Yunhu’s SaaS and cloud system can connect with tens of thousands of mini programs in software, drugs, machineries, medical education etc. In this way, problems with small clinics such as poor medical information flow, lack of professional knowledge and weak profitability will no longer be problems.

“It’s a typical case of technology enabled industry sector, with light + heavy business model, technology empowers a seamless online + offline connection. Enabled by Yunhu, these small clinics will transform from an “ordinary convenient store” to “FamilyMart” in the community. Patients and doctors can be old friends for years, a warm relationship with improved medical service quality” said Patrick.

Periodic economic fluctuation can be ignored for these innovative companies with first- mover advantages. “For instance, recruitment industry is strongly related to economic cycles. The COVID-19 has caused industry downturn, but why did we increase our investment in Boss Zhipin? In the short-term the pandemic impacted the market demand, but in a long run, you will see outstanding players snap the market share of others.” Patrick cares more about the logic behind the sector and dynamics instead of short-term event.

Patrick is a long-term value investor. Upholding a long-term investment principle protects him in return. When opportunities emerge, he makes decision to make big investment and enjoy the power of compounding for a long period of time. Tantan, a Chinese dating App invested by ZWC, was sold to NASDAQ listed company Momo at nearly $US700 million. Another portfolio company Mobike, a bike-sharing APP, was acquired by HK listed company Meituan Dianping. Both delivered good return.

02
Timing: Make investment in critical turning point to enjoy the best risk-adjusted return

Valuation is the most important element in value investment. But value evaluation, which more often relies on the understanding to industry, company, and people, is particularly challenging. To capture the opportunity of “lower price higher value”, Patrick circled out two scopes for his investment.

Scope 1 is to focus on two major sectors: technology enabled consumer sector and technology enabled business service. Thanks to his ten years of experience in both entrepreneurship and investment, Patrick with his knowhow that covers both sectors.

“Sometimes I look at problems in traditional entrepreneurs’ angel. Accumulation is important for business operations. Traditional entrepreneurs have the will and persistence to refine details, such as the supply chain, which will be reflected in product or operation,” said Patrick, “Entrepreneurs in internet sector tend to have strong innovative abilities and new thoughts. Technology enabled industry sector combines the two.”

Scope 2 is to focus on series B and C, or the early growth as internally defined. To capture the critical turning point in early growth stage, where he makes the investment to enjoy the best risk-adjusted return.

“Late early stage to early growth stage, but not late stage,” said Patrick. Technology enabled business service and consumer sector are not winner takes all. “Though Perfect Diary, a young Chinese makeup brand, experienced rapid growth, other cosmetics brands also delivered growth. While in enterprise service sector, several companies compete in the same sector. The top five companies have a better chance of winning but the stronger one will always stand out, these leading companies likely to take 80% market share. Investing too late will lower the ROI.”

Investing too early with more uncertainties have higher chance of failure during the second half of internet industry. While investing too late will result in investor competition and higher valuation. ZWC focuses on early growth stage based on Patrick’s judgment over the critical turning point.

Taking the recent investment in Kuaitu Logistics as an example of technology enabled industry sector, ZWC conducted a detailed research of China’s large-size Less-than- Truckload industry. On the demand side, thousands of SMEs are working on servicing demand from lower tier cities. Scattered logistics require more efficient and lower-cost one-stop door-to-door services, meaning the market has been educated. while in the supply end, the CR10 of China’s large-size Less-than-Truckload market is below 5%, the market is extremely fragmented. “Post COVID-19, industrial consolidation will accelerate in our view. Another unicorn like SF Express may rise in China’s large-size Less-than-Truckload industry, therefore we need to act fast.” said Patrick.

03
Cornerstone: identify signals from research

How can front-line investors seize the critical turning point with a long vision? Patrick refers to research ability as he tries to generalize the question. Research ability can be divided into three tiers according to Patrick.

Tier 1: Seek signals in current events.

In technology enabled consumer sector, ZWC has been continuously conducting user researches and tracking shift in user behavior, including data-driven and opinion-driven research. The former is a quantitative analysis by studying user numbers and trend changes; the latter is to find behavior pattern via user communication.

In enterprise services sector, ZWC tries to find the pain points hidden across the industrial value chain through in-depth research such as management interviews, expert, and customer interviews. ZWC continuously studies in-depth knowledge of the sector and thus allowing it to capture the signal in earlier stage.

Tier 2: Prioritize signals and make optimal investment timing decision for different industries
From industry perspective, first you need to assess market size and growth potential.
“Sometimes the market size can hardly be assessed, or it may appear too small. For instance, investors initially doubt about the market size of food delivery segment. The establishment of unicorn Meituan Dianping and ELEME proved the market size and growth potential. Investors need to do a lot of research and due diligence to be able to see this.”

Other important factor to consider is competitive landscape including the players, the strategies and competition situation.

Systematic tracking with continuously efforts is the key once the industry is set. “First choose the industry based on signals, then we identify players to study their business and performance, narrow down until we lock down the right investment target.” said Patrick.

ZWC studies three core capabilities of an innovative company. Firstly, product driven, companies like Tencent, Facebook, Google in technology industry and lululemon, Uniqlo from consumer industry create an economic of scale thanks to their products. Secondly, operations driven. The second half of internet industry requires refined operation instead of capital driven. Thirdly, culture driven. Corporate culture symbolizes values and competence.

“It’s a systematic and long-term study. We will not invest in a company based on short term interests. We track and identify the critical turning point to figure out the best investment time” said Patrick.
Yunhu Technology was invested with such methodology. ZWC observes the unsatisfied demands for better medical service of 800 million Chinese in lower-tier cities. Follow the lead, the team studied China’s primary healthcare sector and analyzed multiple segments from its social and commercial values. In the end, ZWC identified Yunhu Technology, an Internet based healthcare platform.

Tier 3: Due Diligence. Besides routine financial and legal due diligence, human resources due diligence is another unique aspect Patrick considered.

As Lu Buwei, a businessman during the Warring States period in China, once said, “Investing in people and make huge return”. Behind every successful investment of Warren Buffet stands an exceptional manager. In human resource due diligence, Patrick cares about how founders and key executives compliments each other, and founder- market fit. Founder with innovative thinking may not be the right manager in charge of day-to-day operation.

“We accumulate research findings in our internal IT system, and it becomes our knowhows. Combining data and opinion we create a research system to track and cope with changes in a long run. We define questions and capture the turning point based on observation of dynamic environment.” Said Patrick. From published information of secondary capital market, ZWC forms investment thesis to find opportunities in private equity market.

04
Standard to evaluate business moat

Only companies with moat will be able to enjoy long-run growth. Companies at its early growth stage are still in the process of building a moat. Judgement need to be made on whether the company have the capability and condition to create moat. To Patrick, capability and industrial condition are two separate issues.

Capability refers to corporate culture, technology, product, operation, and abilities of resource integration. Industrial condition means once you choose an industry sector, each industry has its own mode of operation and the chance to successfully build moat in the future is subject to the industry and operating model the company chooses.

Pat Dorsey, partner of the world top rating agency Morningstar, classified four moats for picking quality companies: 1) Intangible assets such as brand, patents or permits a corporate owns. 2) High switching cost. Users are reluctant to switch even similar product appears, i.e. WeChat. 3) Network effects, meaning company value increases as their number of users increases. 4) The cost advantages.
“The new economy, innovative or blue-sea market that ZWC focuses on, require our judgment most of the time,” said Patrick.

Successful investments based on research, time, and people. The process of decoding key elements through research and study thrills Patrick. “Many see uncertainties, but we see certainties based on our day-to-day in-depth industry analysis.”

Warren Buffet once mentioned the Splendid Splinter Ted Williams. As one of the greatest hitters in history, Ted studied all matches and broke the strike zone into 77 baseball sized spaces and pictured them on the board. Swinging only at balls in his “best” cell could offer him highest odds of success.
Patrick also has a board at heart. He is like a hitter waiting for his best timing, when the good ball comes, he will be in his best position to hit the ball.